The new China syndrome

LIKE NEARLY everything else in the world these days, it now appears that global stock market corrections are made in China. The rout Tuesday that began in China may have been an anomaly, or the start of something big. But I have long felt that something has to give in China. This may be the beginning of an important venting process.

The basic story about China is that despite its remarkable successes on the economic development front, the nation has a seriously unbalanced economy. The main problem is a runaway investment boom.

By Morgan Stanley estimates, fixed-asset investment -- spending on housing, commercial buildings, factories, infrastructure and other property -- exceeded 45% of China's gross domestic product in 2006. This is a record for China and, in fact, a record for any major economy in the world. By comparison, Japan's investment ratio in the 1960s -- the period of maximum rebuilding from the destruction of World War II -- never exceeded 34% of GDP. China's annual growth in fixed-asset investment has averaged 26% over the last four years. Should investment continue to run at this pace, it could lead to a Japanese-style deflation. That's the last thing China wants or needs.

The Chinese government recognizes the perils of such a possibility. For nearly three years, it has conducted an on-and-off campaign aimed at cooling its overheated investment sector. Following relatively limited actions first implemented in the spring of 2004, Chinese authorities have upped the ante in the last eight months. The People's Bank of China has raised a key short-term interest rate twice, totaling slightly more than half a percentage point, and beginning in mid-2006, the central bank boosted bank reserve requirements five times, going from 7.5% to 10%, the last such action taking effect last Sunday. The problem for China is that it is still very much a blended economy -- both state and market driven. As such, monetary policy actions have had limited success at best.

Dominated by a vast and highly fragmented system of autonomous local bank branches, much of China's bank lending remains outside the control of its monetary authorities. As a result, Chinese officials have had to rely largely on "administrative controls" -- a case-by-case approval mechanism -- to rein in the excesses of runaway investment.